ARE133 Midterm

Consumers can consume as much as they want for a fixed fee; a two-part tariff where the piece rate = 0

Flat rate pricing

The idea that money in a savings account is different than money in a checking account is an example of segmenting. (T/F)

True

What is one possible way a non-economist would describe preferences that display distaste for linear pricing? a) A preference for convenience. b) A preference for self-control. c) A preference for getting a good deal. d) A preference for unlimited consumption.

a) A preference for convenience. (Consumers might prefer flat rate pricing because they won't have to pay every single time. We showed that it is often not a good deal.)

The endowment effect is: a) The difference in willingness to pay and willingness to accept when there should not be a difference. b) Always in violation of the rational model. c) Describes the bias of individuals endowed with more money. d) An increase in utility from more income.

a) The difference in willingness to pay and willingness to accept when there should not be a difference.

Behavioral economics is the study of how _______________ human behavior impacts the allocation of scarce resources. a) Predicted b) Observed c) Irrational d) Rational

b) Observed

What types of tools do all rationally bounded individuals use to make a decision? a) Calculators b) Advertising c) "Rule of thumbs" or heuristics d) Their friends

c) "Rule of thumbs" or heuristics

The sunk cost fallacy occurs when: a) Losses hurt more than gains. b) Gains or losses are compared to some reference point. c) I attempt to recover past costs by continuing an activity when there is a negative return. d) My utility function contains a bliss point.

c) I attempt to recover past costs by continuing an activity when there is a negative return.

The following statements about excepted utility theory are all equivalent except: a) For all gambles an individual's certainty equivalent equals 0, xCE = 0 b) E(u(x))=u(E(x)) c) The individual is risk averse. d) The individual is risk-neutral.

c) The individual is risk averse.

The gain from consuming a good and the loss from paying for purchasing the good is known as: a) Transaction utility. b) Loss aversion. c) Consumption utility. d) Acquisition utility.

d) Acquisition utility.

Explain when one should integrate and segregate accounts.

- Integration: If two losses combine to be a smaller loss in utility through integration (v(-34)) than segregation (v(-30) + v(-4)) - Segregation: If two gains combine to be a higher/more pleasurable gain in utility through segregation - If there are gains and losses, integration (v(30-30) = v(0)) may be better than segregation (v(-30)+v(30)) due to loss aversion

What are the 2 models used in bounded rationality?

1) Behavioral Model: Seeks to describe behavior (empirical observations) - Only tells us "what" 2) Procedurally Rational Model: Attempts to provide a reasoned decision mechanism (rational or logical deliberation) - Tells us "why"

What are 4 assumptions of the rational choice model?

1) People have well understood and stable preferences, know the results of their choices, and will make the best possible choice 2) Assumptions are complete and transitive 3) Utility is increasing in x1 and x2 (they are "goods")

Because budgets are treated as non-fungible, people can use accounts to limit temptation. What 3 accounts are proposed?

1) current income 2) current wealth 3) future wealth

Anne and Jim participated in an experiment about the willingness to pay for a set of head phones. Jim is suggested a price of $22 and Anne is suggested a price of $13. The experimenters conclude that both Anne and Jim use the anchoring heuristic to arrive at a final willingness to pay. What are possible values of their willingness to pay: a) Anne: $15. Jim: $30. b) Anne: $30. Jim: $30. c) Anne: $13. Jim: $13. d) Anne: $25. Jim: $15.

Anne: $15. Jim: $30.

A common marketing technique that advertises some good at a price well below some regular price. However, when the customer arrives, the advertised good is sold out or otherwise not available, but some similar good at a modestly higher price is available.

Bait-and-switch approach

Systematic deviations from the rational model

Behavioral anomalies

The study of how scarce decision resources are allocated - Focuses on systematic deviations from the optimal decision and how observed behavior impacts allocation

Behavioral economics

When individuals rationally simplify their problems, choices, and outcomes by narrowing the set of possible choices and characteristics they consider

Bounded Rationality (Simon)

Diminishing marginal utility in gains, but also diminishing marginal pain from losses

Diminishing sensitivity

The tendency for people to value an object more highly if they possess it than they would value the same object if they did not

Endowment effect

The ability to apply an estimated relationship more broadly, e.g. to forecast behavior

External validity

A firm must consider its fixed cost and its marginal cost when deciding how much to produce. (T/F)

False

An individual's utility function is always expressed in terms of dollars or money. (T/F)

False

Consider two bundles x and y and a reference point r. If x ~ ry then it must also be true that x ~ r and r ~ y. (T/F)

False

Mental accounting is an alternative concept to transaction utility. (T/F)

False

Regret and temptation are key features of the rational model. (T/F)

False

There are three bundles of goods: x, y, z. A consumer has preferences such that x >> y, y >> z. If x ~ z then the consumer's preferences cannot be described as transitive. (T/F)

False

Transaction Utility describes the scenario in which a consumer spends too much on a good. (T/F)

False

Two-Part Tariffs affect the consumer's utility function. (T/F)

False

Whether a consumer is better off "integrating" or "segregating" is independent of whether he/she/they are experiencing multiple losses or multiple gains. (T/F)

False

The status quo bias is necessarily inconsistent with the rational model. (T/F)

False. An individual may choose to stick with the status quo instead of looking or a new good may simply be averse to the uncertainty or because preferences are stable over time and what was chosen before should still be utility maximizing today.

A decision-maker always arrives at different choices if he/she/they segment their decisions. (T/F)

False. Under segmentation independence, the optimal choice given by simultaneous decisions is the same choice given by the segmented decision.

When does a reference structure display loss aversion?

If for any consumption bundles and reference points satisfy the condition, x>ry whenever x~sy

When does a loss averse reference structure display diminishing sensitivity?

If for any consumption bundles and reference points satisfy the condition, y>rx whenever x~sy

Explain the Rational choice model with income from varying sources and contrast it with the theory of Mental accounting

If max U(x1, x2) is subject to p1x1 + p2x2 < y1 + y2, y1 is income from Source 1 and y2 is income from Source 2 and total income is k = y1 + y2

The ability to establish a causal link between decision variable and observed behavior

Internal validity

What would be some limitations of rational explanations?

Limitations of food, options, etc.

Charging a fixed price per unit; a 2-part tariff where piece rate = 0

Linear pricing

People's tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5. -Kink at the origin and different slopes; marginal losses are more painful than marginal gains

Loss aversion

A theory of grouping and categorizing money and transactions so that the individual may systematically evaluate potential tradeoffs. • Spending is categorized into separate budgets for various types of items

Mental Accounting

When people separate the payment, through time, from the consumption of a good

Payment decoupling

The reluctance to close accounts even with losses fades

Payment depreciation

The process of explaining how beliefs and evaluations emerge from correlations between what people experience and what they feel, is influenced by the default option

Preference formation

Loss is negative consumption, and thus diminishing marginal utility of loss is identical to increasing marginal utility of consumption

Prospect theory

The baseline microeconomic model that often defines how people should behave - Defines rationality as evaluative and consistent

Rational choice model

A general preference for things to remain as is. If people have been in a particular state for a long time, they might take this state as the reference point.

Status quo bias

Occurs when an individual tries to recover sunk costs by continuing an activity for which there is a negative return

Sunk cost fallacy

What happened when some were given cash and some were given SNAP (food stamps) to low income families for food?

Those with cash spent significantly less on food

The utility one receives for feeling they have received greater value in a transaction than what they have given away in paying for the good or service

Transaction utility

Acquisition utility refers to the utility I receive from consuming a good and transaction utility is the utility I derive from feeling like I got a good deal. (T/F)

True

An individual's certainty equivalent is the amount of money the individual must receive with certainty in order to attain the same level of utility as the expected utility of a gamble or uncertain event. (T/F)

True

Diminishing Sensitivity implies that when there are two goods (i & j) and when I expect less of good i, then to give up a set amount of good i, I need to be compensated with less j then when I am initially expecting more of good i. (T/F)

True

If preferences are complete and transitive then utility curves will never intersect. (T/F)

True

Mental accounting is a theory of how individuals group and categorize money and transactions so that they can more easily evaluate the trade-offs. (T/F)

True

Narrow bracketing can lead to addiction because I consider the benefits of my addictive behavior today separately from the costs it will impose on me tomorrow. (T/F)

True

The policy implication of the default option bias is that policymakers can set a desired choice as the default option. If the default option bias is present then this increases the likelihood that the government's choice is implemented. (T/F)

True

Under the rational choice model, a default option should hold no special place in the mind of the individual decision maker.

True

Loss of value from giving up good or service (Compensation)

Willingness to accept

Value of acquiring a good or service (Payment)

Willingness to pay

A tendency to broadly bracket decisions may be evidence of a) A diversification bias. b) Melioration. c) A status quo bias. d) A default option bias.

a) A diversification bias.

What is the main difference between a behavioral model and a procedurally rational model? a) Behavioral models are not based on any particular assumptions, whereas procedurally rational models are. b) Procedurally rational models do not depart from the rational model, whereas behavioral models do. c) Behavioral models tell us why individuals make certain choices, whereas procedurally rational models do not. d) There are no differences.

a) Behavioral models are not based on any particular assumptions, whereas procedurally rational models are.

Strictly decreasing marginal utility from gains implies what about the slope of the value function in the domains of gains? a) Concavity. b) Linearity. c) Convexity. d) None of the above.

a) Concavity.

There are two local bars and I always buy the same beer at both bars. At the first bar, the music is bad and the bartender is rude. At the second bar, the music is wonderful, there are lots of friendly people, and I always enjoy myself more than when I go to the first bar. An example of context adding value to a good is: a) I pay a dollar more for the beer at the second bar than I pay at the first bar. b) I pay $10 for a beer at the second bar. c) I never go to the first bar. d) I stop talking to the bartender at the first bar.

a) I pay a dollar more for the beer at the second bar than I pay at the first bar.

Experiments: Two economists team up with the local basketball team to manipulate the pricing of season tickets. The first 100 fans that signed up for season tickets paid full price, the next 100 fans got a 10% discount and the next 100 fans received a 20% discount. They then compared the attendance across the different categories of discounts to see whether those who paid full price were more likely to attend the games. a) Would this experiment allow you to credibly test the sunk cost fallacy? b) Why or why not? Briefly explain.

a) No. b) The related experiments described in textbook and class randomly assigned theater-goers to the different discount categories. The experiment described above does not. It could be that the first 100 fans to sign up for season tickets get more utility from attending games than the last 100 since they were the first to go to the box office to buy season tickets (e.g., the order in which they get to the ticket office and receive the discount is correlated with their valuation). This means that an increased rate in attendance among the full price group cannot necessarily be attributed to the sunk cost fallacy.

Application: A consumer knows that he/she/they will go to the gym 10 times or less every month for 12 months. He is offered two types of memberships. The first membership is a flat monthly rate of $55 for unlimited use. T he second membership plan is a $10 one-time fee and $5 per visit. a) The consumer decides that he/she/they should buy the first membership plan. Is that the correct choice? Briefly explain. b) What type of bias explains this choice? Briefly explain. c) Assuming the consumer is affected by payment depreciation, what would you expect about gym attendance if he/she/they can pay the membership fee in full (with a slight discount resulting in $600 overall payment) at the beginning of the year?

a) No. In a year, the consumer would spend 12*$55= $660 if he chooses the first plan. Given that he/she/they will go to the gym 10 or less times a month, at most he/she/they would pay $10+12*10*$5= $610 on the second plan. b) Flat rate bias. It occurs when consumers choose a fixed-fee option when they would have been better off choosing the per-use (or linear pricing) option. c) The consumer would feel less and less motivated by the payment as it would be a lot less present in their mind as the year goes on. That would mean he/she/they start going less and less.

Concepts: What does loss aversion imply about an increase and decrease of about equal size from a reference point? a) Briefly explain. b) Briefly describe the relationship between the default option and the "anchoring and adjustment" mechanism by relating them both to the concept of a reference point.

a) The implication of loss aversion is that an increase above a reference point has a much smaller utility gain than the equal size decrease below the reference point. Or in other words, the convex function over losses is steeper than the concave function over gains. b) In the absence of complete preferences the default option provides a reference or anchor for an individual with a default option bias. Once this anchor point (either through a default option or through framing the question or scenario with unrelated information) is suggested, then individual may adjust their preferences accordingly using this value as an initial reference.

The below figure shows three utility curves. Which of the following statements is not true? a) Utility increases as you move upwards along a utility curve. b) On a single utility curve, the level of utility is constant. c) Utility decreases as you move to utility curves towards the origin, x1. d) Utility is an ordinal measure.

a) Utility increases as you move upwards along a utility curve.

A relationship between x and y has been estimated in an experimental setting. If this relationship can be broadly applied outside of the laboratory, then the experiment is considered: a) internally valid. b) externally valid. c) a natural experiment. d) a quantitative experiment.

b) Externally valid

Payment decoupling is best described as: a) The idea that losses hurt more than gains. b) The idea that the payment and consumption are separated by time and do not seem as closely linked. c) The idea that people suffer from the cognitive costs of choosing which bundle to purchase. d) The idea that I take sunk costs into account when making consumption decisions.

b) The idea that the payment and consumption are separated by time and do not seem as closely linked.

A consumer typically buys toothpaste A. He is watching TV one day and sees an advertisement about toothpaste B. He realized that toothpaste B has been available for purchase as long as toothpaste A, but he never knew it existed. What assumption is violated? a) Transitive preferences. b) Increasing utility for normal goods. c) Complete preferences. d) Stable Preferences.

c) Complete preferences.

Segmentation Independence refers to which concept? a) The available choices do not change based on how they are grouped together. b) When all decision-makers make choices simultaneously they make the same choices. c) Decisions of a single individual do not change based on how they are grouped together. d) Elements of your choice set can be broken into smaller pieces.

c) Decisions of a single individual do not change based on how they are grouped together.

What is the main feature of the double-accounting system? a) The gain of some transactions is so great that the benefit is doubled. b) Each transaction is recorded either as a benefit or as a cost. c) Each transaction is recorded twice, once as a benefit and once as a cost. d) The net value of a transaction is always 0.

c) Each transaction is recorded twice, once as a benefit and once as a cost.

A consumer has preferences over 2 goods, U(x1, x2), where p0x1 + p1x1 + p2x2 < y where p0 > 0 and x1 = 1 if positive amounts of x1 are purchased and 0 otherwise. If both x1 and x2 are normal goods and x1 > 0 and x2 > 0, then a decrease in p0 has the following effect. a) Changes the relative price of the two goods: changes the slope of the budget line. b) Has a negative income effect: shifts the budget line towards the origin. c) Has a positive income effect: shifts the budget line away from the origin. d) No effect.

c) Has a positive income effect: shifts the budget line away from the origin.

When an individual uses a comparison to aid making a decision, we often call this a: a) Sunk cost. b) Fixed cost. c) Reference point. d) Decoupling.

c) Reference point.

The most common heuristic in the theory of mental accounting is the segmenting of purchase. The segmenting of purchases means that a) The consumer considers all consumption plans simultaneously. b) The consumer enters each transaction into the ledger simultaneously. c) The consumer enters each transaction on a piecemeal basis and keeps separate accounts for different types of transactions. d) The consumer shares the decision-making responsibility with other consumers.

c) The consumer enters each transaction on a piecemeal basis and keeps separate accounts for different types of transactions.

Suppose a consumer as a value function over gains given by U(z) = z. If x > 0 and y > 0 then which of the following is true? a) The consumer should integrate over gains. b) The consumer should segregate over gains. c) The consumer is equally well off if he/she/they segregate or integrate. d) The consumer should integrate if x and y are allocated to different budgets.

c) The consumer is equally well off if he/she/they segregate or integrate. (Preferences for segregating and integrating are a result of diminishing utility (or pain). Here, we have a linear (constant slope) function and there would be no difference.

What is the difference between the status quo bias and the default option bias? a) No difference. b) The default option bias is a preference for failing to pay back loans, whereas a status quo bias is a bias that results from a preference for the currently chosen option. c) The default option bias is a bias that occurs when there is a preference for a default option and a status quo bias is a bias that results from a preference for the currently chosen option. d) The default option bias is a bias that occurs when there is a preference for a default option and a status quo bias is a bias for what other individuals have chosen.

c) The default option bias is a bias that occurs when there is a preference for a default option and a status quo bias is a bias that results from a preference for the currently chosen option.

An individual whose preferences are given by the indifference curve in the figure below has preferences that violate which of the following assumptions found in the rational model: a) Completeness only. b) Completeness and transitivity. c) Transitivity only. d) Monotonicity.

c) Transitivity only.

All of the following are motivations for employing behavioral models, except for developing ___________ theories. a) Strategic b) Therapeutic c) Unifying d) Academic

c) Unifying

An individual must choose between 4 insurance policies, x1, x2, x3, x4 where x1 is the company's default option. The utility the individual receives from each option is ordered the following way: u(x3) > u(x1) >> u(x2) > u(x4). Which option does the individual choose? a) x1 b) x2 c) x3 d) x4

c) x3 The point here is that default bias is most relevant if consumers don't have complete preferences and are unsure about the utility received from either option. In this question, they do have strong preferences, and will not be affected by the default option.

Bob and Amy have the same utility functions and purchase the same two goods at the same prices. Bob works two jobs. He makes $100 a week at his first job and $500 at his second job. Amy works one job and makes $600 a week. What does the rational model predict about their optimal consumption choices? a) Amy consumes more than Bob. b) Bob consumes more than Amy. c) Bob and Amy consume the same total amount of goods, but different compositions of the two goods. d) Bob and Amy's optimal consumption bundles are the same.

d) Bob and Amy's optimal consumption bundles are the same.

If x1 and x2 are both normal goods and U(x1, x2), then U(x1, x2) necessarily increases if a) x1 increases. b) x2 increases. c) x1 increases, x2 decreases. d) Both x1, x2 increase.

d) Both x1, x2 increase.

The concept of bounded rationality refers to: a) A utility function that cannot be fully described. b) Individuals unable to use "rule-of-thumbs" to make decisions. c) Only individuals who have been well-trained in economics can make the optimal decisions. d) Limits on cognitive abilities, access to information and limits on other necessary resources keep individuals from achieving utility maximization.

d) Limits on cognitive abilities, access to information and limits on other necessary resources keep individuals from achieving utility maximization.

Narrow bracketing of investments in a portfolio of risk assets can lead to which of the following: a) Excess exposure to risk. b) Excess diversification. c) Optimal exposure to risk. d) No risk in the portfolio.

d) No risk in the portfolio.

Losses and Gains relative to a ____ in each account are treated differently according to a ____

reference point; value function

What are 3 possible rational explanations for the sunk cost fallacy?

• Firms or people care about signaling (failure) or what people will think • People receive extra utility from finishing, even if marginal utility becomes negative at times • Firms maximize expected utility rather than profit, and will be influenced by risk aversion